Bernanke on monetary reform

Well this is the post we’ve all been waiting for, isn’t it?  Ben Bernanke has a post discussing options for monetary reform. As you’d expect, it’s a really well thought out post—first rate.  And as you’d expect, I am still able to find a few points where I disagree.  But let’s start with the good stuff:

Of course, no policy framework is without drawbacks, as attested by the difficulties the FOMC has faced in dealing with the zero lower bound on interest rates. If the Committee were to contemplate changing its framework, there are two directions it might consider.

He’s open to alternatives, and recognizes that policy has been less effective since 2008.  The first alternative is a Taylor-like instrument rule, which Bernanke finds useful but a bit too rigid to rely on completely.  Ben shows he’s a natural blogger by providing a long quote explaining why policymakers cannot rely too rigidly on a mechanical rule, before telling us:

As some will have guessed, the quote is from John Taylor’s classic 1993 paper introducing the Taylor rule, “Discretion versus Policy Rules in Practice” (pp. 196-7).

A little bit of teasing from the former Fed chair to (perhaps) the next Fed chair if the GOP retakes the White House. Then the second alternative:

The second possible direction of change for the monetary policy framework would be to keep the targets-based approach that I favor, but to change the target. Suggestions that have been made include raising the inflation target, targeting the price level, or targeting some function of nominal GDP. Some of these approaches have the advantage of helping deal with the zero-lower-bound problem, at least in principle.

That’s good.

My colleagues at the Fed and I spent a good deal of time during the period after the financial crisis considering these and other alternatives, and I think I am familiar with the relevant theoretical arguments.

I’m sure that’s right, and I’m certain there is nothing theoretical that I could have added that would have carried much weight at the Fed.  They’d be better off talking to people like Michael Woodford.  Nonetheless, later I’ll argue that the Fed was not fully aware of the political implications of these alternatives.

Although we did not adopt one of these alternatives, I will say that I don’t see anything magical about targeting two percent inflation. My advocacy of inflation targets as an academic and Fed governor was based much more on the transparency and communication advantages of the approach and not as much on the specific choice of target. Continued research on alternative intermediate targets for monetary policy would certainly be worthwhile.

One of Bernanke’s good qualities is that he’s open-minded.  He obviously sees that given what’s happened since 2008, in retrospect a slightly different approach might have been better.  But of course we can’t rewrite history, and there are credibility issues that constrain policy, as they should.  The italicized phrase may surprise some readers who don’t play close attention.  I’ve always argued that it would have been quite difficult for the Fed to abandon its 2% inflation target right after formally adopting it in 2012.  A central bank that is so cavalier with previous promises would not be trusted any more than the Argentine central bank.

Finally we get to the key three paragraphs:

That said, I want to raise a few practical concerns about the feasibility of changing the FOMC’s target, at least in the near term. First, whatever its strengths and weaknesses, the current policy framework, with its two explicit targets and balanced approach, has the advantage of being closely and transparently connected to the Fed’s mandate from Congress to promote price stability and maximum employment. It may be that having the Fed target other variables could lead to better results, but the linkages are complex and indirect, and there would be times when the pursuit of an alternative intermediate target might appear inconsistent with the mandate. For example, any of the leading alternative approaches could involve the Fed aiming for a relatively high inflation rate at times. Explaining the consistency of that with the statutory objective of price stability would be a communications challenge, and concerns about the public or congressional reaction would reduce the credibility of the FOMC’s commitment to the alternative target.

Second, proponents of alternative targets have to accept the fact that, for better or worse, we are not starting with a blank slate. For several decades now, the Fed and other central banks have worked to anchor inflation expectations in the vicinity of 2 percent and to explain the associated policy approach. A change in target would face the hurdles of re-anchoring expectations and re-establishing long-term credibility, even though the very fact that the target is being changed could sow some doubts. At a minimum, Congress would have to be consulted and broad buy-in would have to be achieved.

Finally, a principal motivation that proponents offer for changing the monetary policy target is to deal more effectively with the zero lower bound on interest rates. But economically, it would be preferable to have more proactive fiscal policies and a more balanced monetary-fiscal mix when interest rates are close to zero. Greater reliance on fiscal policy would probably give better results, and would certainly be easier to explain, than changing the target for monetary policy. I think though that the probability of getting Congress to accept larger automatic stabilizers and the probability of their endorsing an alternative intermediate target for monetary policy are equally low.

There’s much that can be said here, and I’m going to consider the question of Congressional authorization in another post, over at Econlog.  But let me just say here that I think he’s wrong about price level and NGDP targeting, I don’t think they would require Congressional authorization.  A 4% inflation target perhaps would.

Obviously I don’t think fiscal policy would be better than monetary reform, but it’s a moot point as we both agree that Congress is not about to start using fiscal policy to stabilize the economy at the zero bound.  Nor are the Europeans or the Japanese.  Indeed the Japanese sharply tightened fiscal policy in 2014 (and unemployment fell).  So with fiscal policy off the table we need to improve monetary policy to make it more effective.

Reading between the lines, and based on what I’ve read from various insider sources, Bernanke may have the following concerns:

1.  Congress would not like a 4% inflation target.

2.  The Fed establishment hates (price or NGDP) level targeting.  It puts them right in the spotlight, with “ownership” for adverse moves in the nominal economy.  They’d rather be one of many factors making our economy work better.

Here are a few areas where I disagree with Bernanke’s pessimism.  Let’s start with communication.  It’s often claimed that it’s easier to communicate an inflation target than a NGDP target.  “The public understands inflation.”  No they don’t!!! They don’t have a clue as to what inflation means.  Most of my students were far above average, and yet when I would ask them the following question (as economics major seniors), 90% would get it wrong:

If all prices rise 10% and all wages and salaries also rise 10%, has the cost of living actually risen?

Most say no, whereas the correct answer is that the cost of living rose 10%.  Bernanke discovered this in 2010 when core inflation fell to 0.6% and the Fed announced it was going to try to raise the cost of living for Americans, to help the economy.  Talk radio went nuts, and Bernanke ran into a firestorm of criticism.  It sounds “bad.”  The Fed may correctly view 2% as a symmetric target, where misses in either direction are bad, but the public sees it more like the ECB, the lower the inflation the better.  That’s because the public thinks their own nominal income is unrelated to changes in the cost of living, whereas the Fed believes that monetary stimulus will boost RGDP, and this causes the average American’s nominal income to rise even more than inflation rises.  Inflation targeting is a communication nightmare.

Second, Bernanke seems to overlook the fact that even with its current dual mandate there are times where the Fed must pursue an inflation rate higher than 2%.  Indeed if it were not true, if they always focused like a laser on 2% inflation, then they’d have a single mandate, and their policy would be indistinguishable from a central bank with a single mandate.  In fact, when there is a severe adverse supply shock, such as an oil embargo, the Fed does aim for above 2% inflation.  In this respect, NGDP (growth rate) targeting is very similar to current Fed policy.  As far as price level targeting, the Fed could easily argue that aiming for a long run 2%/year rise in the price level is more consistent with their Congressional mandate, as it provides more long price level predictability that inflation targeting (where the price level has a random walk element.)

I’ve already indicated that the “blank slate” argument is a genuine concern.  But I also have argued that there are creative ways of addressing this issue.  A likely compromise would involve the Fed setting intermediate NGDP target paths every 5 years, where the target growth rate was the Fed’s estimate of trend RGDP growth, plus 2% inflation.  That would keep inflation close to 2% in the long run, while gaining some of the advantage of NGDPLT over the business cycle.  For those who worry that inflation would vary somewhat, recall that under current policy inflation reached almost 5% in mid-2008, and then fell into negative territory over the next year.  That doesn’t seem very stable to me.

As far as communication, the Fed should continue to communicate to the public that it has a 2% inflation goal (if that’s indeed what Congress wants) but communicate to the markets that it has an intermediate NGDP target that it thinks is most consistent with its combined inflation/employment goals.

And finally, I think some of the concern that NGDPLT might be inflationary was due to the fact that the issue happened to gain traction at a very unusual point in US history, where trend RGDP growth was falling from 3% (over more than a century) to 2% or even slightly less.  But that’s likely to be a fairly rare occurrence.  God help us if the rate keeps falling to zero.  In that case monetary policy will be the least of our concerns.  We’ll be broke.

HT,  Patrick Sullivan, Ken Duda, Britonomist

Is modern macro to blame?

There are some recent posts by David Andolfatto, Mark Thoma and Noah Smith, discussing whether modern macro failed us in 2008.  I don’t disagree with claims that we should not have been expected to predict the financial crisis (if these crises were predictable then they would not occur.)  Rather I’d like to approach the issue from a different perspective. When economists discuss the state of macroeconomics circa 2008, they generally take one of two positions:

1.  Macro is fine, it’s not our fault.

2.  Macro screwed up because they didn’t pay enough attention to ________, where the missing name is the person judging the condition of macro.

I’m sort of in the second group.  But I’ll make things a tad more interesting by claiming that they didn’t just ignore my advice; macroeconomists ignored their own theories.  Here are some parts of mainstream macro, circa 2007, that were almost totally ignored a year later:

1.  Monetary policy continues to be highly effective at the zero bound.

2.  Interest rates and/or the money supply are not good indicators of the stance of monetary policy.

3.  The Great Depression was caused by tight money, not banking distress.

4.  Fiscal stimulus is mostly ineffective due to monetary offset.

5.  Extended unemployment benefits raise the unemployment rate.

If economists had kept believing in 2008 what they believed in 2007, the Great Recession would have been the little recession.  In Europe it was even worse, as economists didn’t even seem to recognize that Great Recessions are caused by adverse demand shocks.  On the other hand European economists seemed to be a bit more skeptical about fiscal stimulus, AFAIK.

PS.  I have a post over at Econlog looking at the question of whether the Fed is allowed to create NGDP futures markets, a question recently raised by David Andolfatto.

HT:  Gordon



The ECB has expected AD growth right where it wants it

Vaidas Urba sent me the latest ECB report:

The March 2015 ECB staff macroeconomic projections for the euro area foresaw annual HICP inflation at 0.0% in 2015, 1.5% in 2016 and 1.8% in 2017. In comparison with the Eurosystem staff macroeconomic projections published in December 2014, the inflation projection for 2015 had been revised downwards, mainly reflecting the past fall in oil prices. In contrast, the inflation projection for 2016 had been revised slightly upwards, also reflecting the expected impact of recent monetary policy measures.

As regards measures of longer-term inflation expectations, the ECB Survey of Professional Forecasters for the first quarter of 2015 indicated that the expected five-year-ahead inflation rate was 1.77%. Medium and long- term market-based measures, such as forward inflation-linked swap rates, had broadly stabilised since the previous monetary policy meeting.

.  .  .

With regard to the monetary policy stance, the members generally shared the assessment that significant positive effects from the monetary policy decisions taken on 22 January 2015, in conjunction with the package of measures decided in June-September 2014, could already be seen, namely an easing in financial market conditions and in the cost of external finance for the private economy. Moreover, recent data on economic activity had been somewhat positive and there were signs of a turnaround in inflation dynamics, including a stabilisation in market-based measures of inflation expectations. This provided grounds for “prudent optimism” regarding the scenario of a gradual recovery and a return of inflation rates to levels closer to 2%. It was recalled that the March 2015 ECB staff macroeconomic projections were predicated on the full implementation of all monetary policy measures taken by the Governing Council, including the expanded APP comprising monthly purchases of €60 billion, which were intended to be carried out until the end of September 2016 and, in any case, until the Governing Council saw a sustained adjustment in the path of inflation consistent with the aim of achieving inflation rates below, but close to, 2%. The March 2015 projections should therefore not be interpreted as suggesting that the latest monetary policy measures were less necessary. On the contrary, they confirmed that full implementation of these measures was required to deliver on the Governing Council’s mandate. At the same time, the Governing Council would continuously assess the effectiveness of the measures and would regularly review progress towards the attainment of the objectives as evidence accumulated over time.

The ECB thinks the current stance of monetary policy is just right.  (I think that’s crazy, but it doesn’t matter what I think.) The ECB also called for structural reforms, but pointedly did not ask for fiscal stimulus, indeed cautioned against slacking off on the deficit reduction targets.  Given their insane monetary policy, their stance on fiscal policy makes sense.

For instance, suppose the Germans were suddenly to do lots of fiscal stimulus, what effect would that have?  Both theory and empirical evidence suggest it would be a beggar-thy-neighbor fiscal policy.  The ECB believes it would have to tighten monetary policy to avoid overshooting their 1.8% inflation target.  Yes, the German stimulus would boost NGDP in Germany. However since overall eurozone NGDP would be stabilized via monetary offset, non-German NGDP would have to decline. This might occur through a stronger euro, for instance.

Indeed this is exactly what happened in 1992, when German fiscal stimulus associated with reunification led to a stronger ECU, which drove countries like Britain and Sweden deeper into recession and eventually out of the EMS.

The ECB may be completely incompetent at monetary policy, but give them credit for opposing the type of fiscal policies that caused all sorts of problems in 1992.

PS.  Also give the ECB credit for understanding the circularity problem—note the last portion of the third paragraph quoted above.

PPS.  I don’t know if anyone’s trademarked “beggar-thy-neighbor fiscal stimulus” yet, but if not I get first dibs.

Monetary policy is not about banking

When I advocate something like QE or negative interest on reserves, I often get people complaining that this will not boost bank lending, or that we shouldn’t even be trying to boost bank lending.  It almost makes me want to tear out my hair. What in the world does banking have to do with monetary policy?  Yes, it may or may not boost bank lending, but it doesn’t matter, as monetary policy is about the hot potato effect.  And yes, the Fed should not be trying to boost lending, any more than it should try to boost sales of microwave ovens.  NGDP is what matters.

Jim Glass directed me to a new study by the Bank of England, which confirms that monetary policy is about the hot potato effect (aka portfolio rebalancing channels) not bank lending.  Here is the abstract.

We test whether quantitative easing (QE) provided a boost to bank lending in the United Kingdom, in addition to the effects on asset prices, demand and inflation focused on in most other studies. Using a data set available to researchers at the Bank, we use two alternative approaches to identify the effects of variation in deposits on individual banks’ balance sheets and test whether this variation in deposits boosted lending. We find no evidence to suggest that QE operated via a traditional bank lending channel (BLC) in the spirit of the model due to Kashyap and Stein. We show in a simple BLC framework that if QE gives rise to deposits that are likely to be short-lived in a given bank (‘flighty’ deposits), then the traditional BLC is diminished. Our analysis suggests that QE operating through a portfolio rebalancing channel gave rise to such flighty deposits and that this is a potential reason that we find no evidence of a BLC. Our evidence is consistent with other studies which suggest that QE boosted aggregate demand and inflation via portfolio rebalancing channels.

PS.  I have a new post over at Econlog that is far more important than this post.  Read the whole thing.

Second thoughts on negative IOR

My very first blog post after the intro discussed negative IOR.  I also published a couple short articles discussing the option in early 2009.  Six years later, what can we say?

1.  I was wrong in assuming the zero lower bound was only 1 or 2 basis points negative.  I made that assumption because in the 1930s and early 1940s T-bill yields never went more than a couple basis points negative.

2.  Being wrong about the zero lower bound made me even righter than I anticipated about the effectiveness of negative IOR.  I argued that people and institutions didn’t particularly want to hold huge amounts of currency, and that assumption was much truer than even I expected.

3.  There was a period where some contrarians were suggesting that negative IOR is a contractionary policy.  I thought that was wrong, as it reduces the demand for the medium of account.  Now I think it’s pretty clear that the contrarian view is wrong.  Negative IOR weakens a currency in the forex market.

4.  Points 1, 2 and 3 seem to make negative IOR a more attractive policy, but if anything my views have evolved in the other direction.  I’d prefer to focus on monetary policy tools like QE and forward guidance, which allow you to exit the zero bound more quickly.  Ultra low rates mean policy has been too tight.

5.  When I originally proposed the idea it was seen as being slightly wacky (even by me.)  Now you have negative yields on 8-year German bonds and 10-year Swiss bonds.  Negative rates are an important part of the modern financial world. Lesson?  Never say never.  NGDP futures might look like a wacky idea today, but back in 2009 the idea of negative yields on 10-year government bonds seemed far, far wackier.  We always need to search for the best options, and let the conventional wisdom catch up when it’s ready.

PS.  Back in early 2009, MMs were the only people saying monetary policy was MUCH too tight.  Matt Yglesias points out that recent events suggest that we were right:

For the USA, the main implication [of negative interest rates] is that back in 2009 and 2010 the Federal Reserve made a mistake. All the objective economic metrics at the time said the “right” interest rate to curb unemployment would be negative. But negative interest rates are impossible! The Fed tried a few tricks to get around that problem, and also told Congress to try fiscal stimulus as a workaround.

The implication of the European experience, however, is that the Fed could have generated negative interest rates through a mix of Quantitative Easing and negative interest rates.